Puerto Rico bond turmoil sparks warning from muni fund

BenEisen

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NEW YORK (MarketWatch) — The municipal bond arm of OppenheimerFunds warned investors Wednesday of risks from the Puerto Rico debt it holds, publicly acknowledging concerns that led to steep investor redemptions and a year of losses in Puerto Rico debt.

Oppenheimer Rochester, a division of OppenheimerFunds, which is in turn owned by Massachusetts Mutual Life Insurance Company, has one of the highest relative exposures to Puerto Rico bonds of all municipal bond fund complexes. Over 17% of the $26.91 billion in assets under management in Rochester’s 20 funds are invested in Puerto Rico debt, according to Morningstar data through the end of last year.

That bet has become increasingly fraught in recent months as prices on the debt have dropped on fears over Puerto Rico’s financial health. All three major rating agencies cut the bonds backed by the Commonwealth’s taxing power to junk in the past two weeks, which could cause even more price volatility as investors exit the market for Puerto Rico debt. In the last 12 months, Standard & Poor’s Puerto Rico muni index dropped 21.3%, rare losses for the municipal bond market, which is often sought for its perceived safety.

Amid the commotion, Rochester has stood by Puerto Rico, emphasizing the government’s strong willingness to make good on its bond obligations and the attractive yields it provides. But investors haven’t shared that confidence. Investors pulled $6.20 billion from Rochester’s 20 funds last year.

Rochester late Tuesday attached supplements to its prospectuses, warning of risks related to Puerto Rico. It also published two articles to its website Wednesday explaining its views on the ratings downgrades. The firm noted that it isn’t required to sell Puerto Rico debt as a result of the downgrades, but those funds that have a capped exposure to junk-rated bonds cannot purchase more junk debt until its holdings are trimmed to meet requirements.

“We are well aware of the market dynamics and the large amount of attention that the fiscal situation in Puerto Rico has garnered, which is likely to affect market behavior,” Rochester said in one article.

The disclosures follow an investigation into Puerto Rico bonds launched last fall by Secretary of the Commonwealth of Massachusetts William Galvin. The inquiry sought information about whether investors were made aware of the risks related to Puerto Rico. Fidelity Investments, OppenheimerFunds, and UBS AG were all sent letters by the secretary. In October, a spokesperson for OppenheimerFunds told the Wall Street Journal the firm “is cooperating fully” with the inquiry.

The $6 billion Oppenheimer Rochester Fund Municipals
RMUNX, +0.46%
had 23.1% of its holdings in Puerto Rico debt at the end of last year, according to Morningstar data. Its fund prospectus was updated to say that because it holds some junk-rated Puerto Rico bonds , the fund is exposed to additional risks. “If the economic situation in Puerto Rico persists or worsens, the volatility, liquidity, credit quality, and performance of the Fund could be adversely affected,” the prospectus read.

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San Juan, Puerto Rico

Puerto Rico has roughly $70 billion in bonds outstanding backed by a patchwork of different pledges and revenue streams. The bonds have long been used to line municipal bond portfolios because of the yield premium they provide, as well as their exemption from federal, state, and local taxes.

But the tide began to go out for Puerto Rico as investors focused on the island’s struggling finances in the wake Detroit’s historic bankruptcy filing last summer. Though the commonwealth has taken aggressive steps to cut its legacy costs and balance its budget, its large debt burden and sluggish economy prompted the rating agencies to downgrade its general obligation debt, as well as other related Puerto Rico obligations. Now, investors are looking to a forthcoming bond sale to see if the island is able to access the market to assure liquidity.

The Rochester fund complex has nine funds that are among the 10 with the most exposure to the commonwealth’s debt, by percentage of holdings tied to Puerto Rico, according to Morningstar data through the end of last year. Sixteen of its funds are among the 19 with the most exposure.

The fund with the most of its holdings in Puerto Rican debt is Franklin Double Tax-Free Income fund
US:FPRTX
, with 60.77% of its assets tied to the island.

While fears grow about an inability to repay the debt, some bonds, such as debt backed by sales taxes known as COFINA sales tax bonds, are considered safer, and have managed to retain investment-grade ratings.

Nonetheless, U.S. municipal bond funds have been pressured to sell their holdings of Puerto Rico debt over the past year, according to Yuriy Layvand, director of fund and asset management at Fitch Ratings. Layvand conducted a survey of 92 closed-end muni funds across six asset managers, which showed that they cut their Puerto Rico exposure by 65% between May and December of last year. For funds that continued to hold Puerto Rico bonds, holdings of COFINA debt dropped.

“This suggests that US funds chose to sell COFINA bonds instead of realizing losses on the more depressed GO and other GO-linked credits,” Layvand said in a Wednesday report.

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